Payout Ratio & Recovery Rate

CFA Level II Fixed Income
#1

In Credit Default Swaps, the recovery rate is the rate that the protection buyer gets in case of default let’s say it is 40%.

The payout ratio , is the amount that the protection seller pays. Based on the curriculum it is equivalent to 1-recovery rate, in that case it is equivalent to 60%.

My question is, should not the two be the same, as the amount paid by the seller is what the buyer gets??

#2

an analogy:

if you own a car is worth $10k… u have it insured, and flood damages it, but it’s still worth $4k. Your recovery is 40%.

insurance payout is (1-recovery) = 60%=$6k.

now you are made whole.

answer to your question is yes, whatever the seller paid Is what buyer gets. But seller only had to pay 60% because buyer didn’t have a total lost.

#3

Thanks that made sense!